How to Trade in Spreads: Expert Tips

Today, markets are unstable and often completely unpredictable. Therefore, a trader who wants to protect his investments should learn how to use spread operations. What it is? A trader playing on the spreader buys one futures contract and sells another similar futures contract, taking profit from the difference in their value and assuming the risk not of the entire futures contract, but only the risk associated with the difference in the price of the two futures. Spreads are of different types, and, accordingly, the ways of using them are also different.

Calendar spreads. To make money on a calendar spread, you should simultaneously buy two futures contracts for the same product or option with different maturities - this can be simply a mechanical hold on a long and short position in the period when the option expires or the game is over. The difference in the dynamics of two related markets. The further you move in time, the more volatility your operation implies. CME Group offers variants of a calendar spread for corn, wheat, soybean, soybean oil and soybean flour. In general, calendar spreads are common in grain markets due to seasonality of planting and harvesting. For example, if it is corn, then it makes sense to consider the spread of July-December: you are selling the old harvest (in July, mostly sold grain last season) and buying a new one. You can do the opposite, buy a December-July spread, selling a new crop and buying an old one. You can trade year-round spread December-December. For wheat, these will be spreads in December-July, July-December or July-July, and for soybeans - July-November (old harvest / new harvest), January-May, November-July and year-round - November to November.

Joe Burgoyne, director of institutional and retail marketing for the American Options Association, explains: "If it's a calendar spread to options, then you're actually buying an option that will not be out soon, but sells expiring this month. So time works for you, since the option of the last month is the most expensive." He adds that it's best to buy a spread at the time when the expired option is the least time left. Burgoyne says: "The calendar spread is a long position where you bet on volatility, which means that you need to represent the level and nature of volatility - especially in a long position; for the cost of short is much more important time factor."

However, in the commodity markets, the usual mechanisms for trading spreads have changed in connection with the emergence of commodity funds, aimed only at long positions. These funds are guided by various commodity indices and extend positions at a predetermined time on the basis of the prospectus of the index. For example, the S&P GSCI (Goldman Sachs Commodity Index) extends positions from the fifth to the ninth working days of the month preceding the expiration of the options. Funds focused on these indices have become so large, - the positions in some crops exceed the commodity balances of last year, - that the nature of some spreads has changed. For example, in seasonal bull markets, supply contracts for the next month were traditionally more expensive than longer options, but due to the scale of the extension, when huge amounts of expiring options are sold, and long positions are extended for the next month, this has changed. There were cases when due to this effect the "bullish spread" (when an option expiring during a month is bought, but longer is sold) lost money in the bull market.

As a countermeasure, many traders began to practice the "bear spread" (selling the expiring option and buying a longer one) before the period of extending the spreads of index funds, trying to make money on this powerful move. This was often effective. But in case of some problems with supplies, spot prices may rise, and in September 2006, it happened - according to some estimates, traders of the Chicago Chamber of Commerce specializing in wheat, then lost more than $ 100 million.

Thus, it can be stated that some traditional mechanisms have changed, and now the trader entering the spreading position should take into account the availability of such funds.

Intermarket spreads. In the case of intermarket spreads, a trader buys and sells various, though often related, goods, and usually deals with contracts with the same maturity. CME Group offers inter-market treasury and swap-spreads between futures on US Treasury bonds and between US Treasury bonds and CBOT Interest Rate Swap futures. ICS Curve Tracker is also offered to track these spreads.

Jeff Quinto, a sales coach with electronicfuturestrader.com, says: "In intermarket spreads, you trade relative changes. Markets tend to some average values ​​and fluctuate in a certain range, respectively, if now it is in its upper part, then we should expect a return to the average."

One example of an intermarket spread is the spread between hard red winter wheat (it is traded at the Kansas City Chamber of Commerce) and soft red winter wheat (it is traded on the CME Group site). Quinto explains that, since hard wheat is used for baking bread, and is exported, and soft cakes and cakes are made, the demand and prices for this raw material will react differently to changes in market conditions. He says: "If you believe that exports will grow, it is logical to buy hard wheat and sell soft. First of all, it's worth drawing graphics and feel how the prices for these two contracts are related. Then see if one of the types of wheat is sold more than the other. If you think that exports will grow, then the situation is favorable for hard wheat. Now look at the graphs, whether this really is happening - whether the market is reacting to a fundamental factor in the way that, in your opinion, it should. Then, after looking at the charts, you decide whether to go into a long position for hard wheat and short for a soft one."

Crack-spread and crash-spread. For some types of goods there are also unique strategies of spread trade. For example, you can buy futures for fuel oil and unleaded gasoline, and sell futures for crude oil, that is, work with the rate of profit of oil refining - this is called crack-spread (from the word "cracking"). If the crack-spread is positive, this means that the cost of processed products is higher than the price of the raw materials, and if negative, then vice versa. There is an important ratio of 3: 2: 1 - this means that of three barrels of crude oil you can get two barrels of unleaded gasoline and one barrel of fuel oil. However, in the US market, unleaded petrol and fuel oil are counted in gallons (in one barrel 42 gallons).

"The idea is simple: you compare the product with its raw material, that is, you play at the cost of processing. If it is a question of crack-spread, the question is how much the finished product is obtained from a barrel of oil. For each of these processes, there is a certain mathematical equation, and on the CME Group website - the appropriate calculator," explains Kevin Kerr, president of Kerr Trading.

Kerr says: "The spread spread plan will depend on your forecast of the specific market's behavior. If you have a mathematical estimate of the amount of crude oil required to produce a certain amount of petroleum products, this is quite enough. Spread trade is one of the most flexible methods in commodity markets," Kerr said.

Another spread, which reflects production processes, is a crash spread - trading a spread between soybean futures and the products of its processing, that is, soybean oil or soybean meal.

Trading techniques. Trading spread is usually less risky than a direct futures position, but it can also be different, so you should be careful. Yes, related markets usually move more or less in one direction, but it happens that information appears that affects only one part of the equation, and then the spread can be as volatile as a direct contract - recall the 2006 example with wheat. In addition, this can occur in markets prone to seasonal factors - such, in particular, the natural gas market.

Quinto says: "Yes, the risk of spread trade is lower than that of a direct contract. Volatility here is usually lower, because it's not about the price of the product, but about the difference between the two prices."

Burgoin agrees: "Compared to a simple purchase of options, spread trading is an excellent means of hedging risk. Both volatility and the funds invested - all this is partly hedged."

"Another advantage of the spread is that it moves slower than a direct contract, which additionally reduces the risks," Kerr adds.

However, those who are just beginning a spread trade are looking for a lot of common mistakes. One of them is a misunderstanding of what is happening in the market.

Quinto says: "Sometimes people imagine the processes taking place too simplistic. My advice: specialize in a limited number of spreads, perhaps even on one - the one that you know best."

Burgon, in turn, indicates that the trader should represent the volatility of options with which he works: "It is important to understand at least about what the price of your instrument will be when its time comes. Just the value of the spread falls and if it is more expensive than the price of performance, and if it is much cheaper. You need to feel volatility, because spread trading is, in fact, a long position on volatility. If, after buying the spread, the volatility begins to decline, the losses can be greater than the drop in the price of the expiring option, where you are in a short position."

Quinto notes that it is necessary to know the stop-loss point: "With spread trade, this is a problem, because there are no automatic stop-loss, you have to do it manually. At some pre-selected moment you need to stop. The people are lulled by the slow spread movement, and they wait, wait until it's too late, so you need clear criteria for the level of risk. When you enter the transaction, you need to decide how much you are willing to invest in it, and clearly adhere to this decision."

Kerr advises to trade a "ready" spread on the exchange, rather than trying to form it independently in the form of two transactions. Yes, sometimes it can be a little more profitable, but the additional risk that after the completion of one part of the transaction the second one will be heavily moved is not worth it. "In addition, he recalls that transaction costs are doubled in the case of spread trade, and he also warns: "If you create a spread yourself, it's very important to carry out the actions in the right order. You first buy and then sell. Markets change quickly, and one should not take on unlimited ny risk."